"I'm beginning to think that these are not perfect storms. I'm beginning to think these are regular storms and we have a sh*tty boat." -- Jon Stewart -- The Daily Show, May 2010

 

The last couple of weeks have seen a return to market gyrations and volatility not seen since the financial crisis of 2007-2008. The culprit this time was a combination of worries about the Greek debt situation and computer trading glitches here at home. In a matter of days, the US market was back in negative territory for the year after showing a 7% gain at the end of April. Nevertheless, the US economy continues to recover, as the most recent jobs report showed a pace of hiring not seen since 2006.

 

So should you reduce your exposure to equities? As always, we advocate making these decisions based on your investment plan, not the emotions triggered by scary headlines. Global stock markets have had an incredible run over the past 12 months, and we've been proactive, when appropriate, in taking some chips off the table and rebalancing our investors' stocks vs. bonds mix in line with their target asset allocation. There are other reasons for which you might want to reduce your allocation to stocks (near-term income needs, etc.). If this is the case, give us a call and we'll help you adjust your investment plan. But remember that having a well articulated plan, and sticking with it, provides the discipline that we believe is necessary for long-term success in investing.

 

Fiduciary vs. Suitability Standard. The recently filed lawsuit by the Securities and Exchange Commission (SEC) against Goldman Sachs brought up an important issue about which most of our clients are unaware. It was no surprise to us that a few days later, Warren Buffett's public support for Goldman Sachs triggered some strong reactions from many commentators. Why would the sage of Omaha, a frequent critic of Wall Street, come to Goldman's defense? We believe that these reactions stem mostly from a misunderstanding of the role that broker-dealers play in our securities markets, and the legal standards that they operate under.

 

At the root of the SEC allegation was Goldman Sachs' role in a deal named Abacus, which was sold to institutional investors. The SEC is charging that Goldman did not properly disclose to these buyers that it, (as well as a hedge fund, which the lawsuit claims was involved with selecting the bonds entering the Abacus portfolio), was shorting the very same securities that it was offering to investors (i.e., Goldman was betting that these bonds would decline in price.)

 

We have no legal opinion on the merits of the lawsuit. However, Goldman pointed out in its defense that it was merely acting as a market maker; it was not advising the buyers on what to do with their money. Consequently, it was acting as an agent, and was only legally required to meet the suitability standard, which mandates a brokerage firm to have reasonable grounds for believing a recommendation fits the needs of a client. Goldman felt that it did meet this standard, and Buffett appeared to agree--commenting that the buyers were sophisticated institutional investors, who "should have done their homework."

 

Unlike Goldman, Bristlecone would violate its code of ethics (and potentially the law) if it were to make an investment opposite that of clients. What separates investment advisers regulated under the Advisers Act of 1940 (such as Bristlecone) from salespeople representing Goldman and other brokerage firms is the fiduciary standard--the very same standard that applies to trustees. As a fiduciary, Bristlecone is required by law to place its clients' interests ahead of its own.

 

In other words, there is a lower level of ethical responsibility between brokers and investment advisers. Stockbrokers typically only need to find investments that are "suitable", whereas registered investment advisers are further required to be diligent in pursuing the clients' best interest. While this may seem to be a trivial distinction, the Goldman lawsuit illustrates that an investment could be suitable but not necessarily in the client's best interest, a distinction which both Goldman and Buffett alluded to in their defense of the firm. In their view, it was up to the institutional investors to decide whether it was in their best interest to buy the Abacus deal. Caveat emptor applied here.

 

At Bristlecone, in an attempt to reduce confusion about legal standards, portfolio managers eat their own cooking by investing alongside clients. This is not a guarantee of competence, but it should bring some degree of comfort that we'll share in the successes and failures of our investment decisions with our clients.